I am a Burmese exile taking a near-permanent refuge in New York and Sydney. Here are my essays about Burma and anything else I feel like writing about. And posting the articles I like from selected sites. Bridging Burma to the world this Blog is more of a Politically-Oriented Literary Blog than a Plain News Blog or a Sophisticated Thoughts Blog.

Thursday, December 1, 2016

Is China Running Out Of Money?

Since the global financial crisis,
China has had a very strong currency, even with the recent devaluation of the
Chinese Yuan. China has a managed exchange rate. The People’s Bank of China
(PBOC) has had to step in to the exchange market to buy any USD coming into
China.

To buy the USD coming into China, the PBOC has had to create CNY for
this purpose. Typically, to soak up these new CNY, the PBOC has issued CNY
bonds, as well as having very high reserve requirements on the banks to control
the supply of CNY.

The PBOC is like any other bank, and it
needs to match assets with liabilities. On the asset side, by far its biggest
assets are foreign reserves. On the liability side are domestic deposits. For
many years, foreign reserves were much larger than deposits, but now the gap is
shrinking rapidly as foreign currency assets fall.

If Chinese foreign reserves continue to
fall and the PBOC wants to maintain control of the exchange rate, they will
need to face some difficult choices. First of all, it could raise interest
rates to try and make the Yuan more attractive and reduce outflows. This
however would be negative for growth, a priority of the Chinese Communist
Party.

The other option is to reduce the
holdings of deposits at the PBOC. The large holdings of deposits at PBOC is
driven by the very high reserve requirements of the Chinese banking system, and
previous cuts in the reserve requirements have reduced deposits at least
temporarily.

This leaves the PBOC with a dilemma.
Raising rates will restrict growth but defend the currency, while cutting rates
or reserve rates for banks will encourage more currency weakness.

One way to think about how high
interest rates need to rise to stop a currency from falling is to look at how
weak a currency has been over the last twelve months. You then compare this to
the difference in 10 year bond rates, and the movement in the exchange rate over
the last 12 months to get an idea of the interest rates increase needed to
attract US dollars.

The idea is that if a currency has been
weak, but interest rates are relatively high, then you are being adequately
compensated. Conversely, if the currency has been weak, and the interest rates
are relatively low, then rates will need to rise. Currently, it suggests
Chinese 10 year rates need to be 6.5% higher, to halt currency weakness.

Given the large increase in rates
needed to slow Chinese Yuan devaluation, devaluation must start to look like
the more likely move. South Korea faced a very similar situation in 1997. In
the mid-90s, Korean foreign reserves began to fall, like they are in China
today. We have added Japanese foreign reserves to show that the fall in
reserves was a Korean specific issue.

Like the Chinese Yuan, the Korean Won
was a managed exchange rate that began to depreciate slowly then quickly.

Below we produce the same graphs, but
replace Korea with China.

Given the huge increase in debt in China
in recent years, such a rate increase seems very unlikely to me. Investors
should be prepared for bigger falls in the Chinese Yuan.